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Wednesday, December 17, 2014

Thin December Markets And Fed Statement Madness

The Federal Open Market Committee (FOMC) concluded its two-day meeting, and gave the world a textual disaster. The FOMC continues to point towards rate hikes starting in mid-2015. Although there have been worries in markets that we are headed towards a repeat of 1998, the FOMC is unlikely to buy into those theories (possibly until it is too late).

Considerable Nonsense In The Statement

In something of a conceptual if not linguistic breakthrough, the Fed both dropped the phrase and retained it. The new language says that the Fed "can be patient in beginning to normalize the stance of monetary policy." On the other hand, it pointed out that this new formula is "consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October."

I am not going to attempt to parse the FOMC language (or the Yellen press conference) here; others are better at that task. I just want to highlight a few basic principles.

The Fed will not hike rates before "mid 2015" (my phrasing). They will have a lot more data to look at before the deed is done, and so what they think now about the exact timing is not too important.

I believe that Yellen hinted that 50 basis point moves are possible, Such rate hikes would probably cause considerable disarray in rates markets. That may be the idea; they may want there to be some risk premia in markets. Although I think the sentiment is reasonable, this business cycle will end sooner or later. If the next recession or financial crisis hits after some wild interest rate moves, the FOMC will be blamed, even if the timing was a coincidence.

The Fed does not care about a lot of financial market behaviour that people in the markets are worrying about. I discuss this further below.

Repeat Of 1998?

People are worried about the current environment being a repeat of 1998. The Fed is not going to share their concerns. The problem is that some market analysts made up the theory that there was a "Greenspan Put", that theory was repeated countless times, and now everybody assumes the Fed cares about the equity market. The only markets the Fed cares about are:

The rates market. They do not want the risk-free yield curve to become unhinged from the fed funds rate. That said, they do not care too much if there is a bond bear market.

The primary credit market (debt issuance). The banking system and the shadow banking system are tightly coupled, as they were reminded during the crisis. That said, they do not worry if spreads widen, as they had been complaining that risk premia were too low. They are only greatly concerned if credit is not available at any price.

The U.S. dollar has a limited impact on trade flows; and so they take it into account. Probably a lot less than currency strategists suppose.

Yes, the oil price fall will blow a hole in the oil sector. This will cause a regional/sectoral recession. However, their thinking is likely to be that the overall economy can survive this sectoral correction; falling gasoline prices will benefit other sectors' activities.

This style of thinking is not the way that many market commentators see it. However, market commentators are too wrapped up in decoding the messages embedded in market pricing, and they tend to panic too often. As Paul Samuelson observed,

To prove that Wall Street is an early omen of movements still to come in GNP, commentators quote economic studies alleging that market downturns predicted four out of the last five recessions. That is an understatement. Wall Street indexes predicted nine out of the last five recessions! And its mistakes were beauties.

Furthermore, Fed economists are wrapped up in a neoclassical world view, where they set the Fed Funds rate based on concepts like the output gap. They do not want to admit that they are forced to react to shenanigans in the financial markets. In literary terms, they want to live in the world of Woodford's Interest and Prices, not Minsky's Can "It" Happen Again?

"Thin December Markets"

I do not have too strong an opinion on recent market action. It is clear that some funds have been blown out, and so positions are being liquidated. For people in finance, if the other guy loses his job, it's a market correction. If you lose your job, it's a financial crisis. Admittedly, for some areas, like the oil patch, there will be definite real world consequences of market moves.

But it has to be kept in mind that we are in the dreaded thin holiday markets. It seems unlikely that anyone is going to want to be a hero and step in front of various oncoming trains a few trading days before year end. But once the books are closed on 2014, there will be a lot more capacity for people to take risk in January. It will only be possible then to see if the weakening of risk assets has legs.

2 comments:

They do not want the risk-free yield curve to become unhinged from the fed funds rate.

I'm sure this is true. This is a perpetual concern of central banks, going back to the Bank of England's mid-19th century worries about "losing contact with the market." But how concretely is this problem supposed to be solved?

And on the theoretical side, how you can reconcile the existence of this problem with the expectations hypothesis? If long rates are normally equal to the expected average value of the policy rate over the term of the loan, how is it possible for the Fed ever lose control of them? This concern seems to better fit my (Keynesian) perspective, where long rates are set based on the expectation of future long rates, i.e. are to a first approximation purely conventional.

The worry would be that forward rates are too high (or too low) relative to where the central banks think expectations could be. Although the central bank only theoretically sets the overnight rate, in practice they need to influence money market rates more generally. If the Fed is setting the overnight rate at 1%, they do not want the entire Treasury curve from 3-months out trading at 5%.

Generally, I do not view this to be a concern. You see some people making yield forecasts that look like that, but those are people who have models for bond yields that do not take into account forwards. But there is a situation (described below) where expectations break down as an explanation. Central bankers would never want to be in that situation.

If investors become worried about default, bonds "trade on a price basis", where all bonds trade for roughly the same price. This is because all bonds would suffer the same haircut. The implication is that the yield curve will invert, as short duration bonds need to rise more in yield to get to the same price. In this case, forwards would make little sense, nor the yield curve.

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